Stress tests were good, but be wary of unseen bank risks

The annual bank stress-test results just released by the Federal Reserve are good news for the United States’ largest banking companies and the U.S. economy, but those results must be viewed with a jaundiced eye for reasons that even many critics of this stress-testing process have failed to recognize. 

The test results do reflect the positive effects of the U.S. economy’s sustained, if sluggish, recovery from the Great Recession. During the eight years since the trough or bottom of that recession, the economy has reached what essentially is full employment in much of the country.

{mosads}The banking industry, too, has had ample time to work through the loan losses caused by the last recession. It has also had time to strengthen its capital base through reduced dividend payments and stock buybacks, as well as, in some cases, raising equity capital. 

The 526 failures of mostly small banks since 2009, as well as the acquisition of weak and failing banks by stronger institutions, has helped to cleanse the banking industry of its weakest players.

Both nationally and globally, the economy is in relatively good shape, despite some troubled areas. While that is good news, it is not-so-good news, too, as downside risks, specifically in the U.S. economy, have steadily accumulated as the recovery from the last crisis has rolled along.

The sustained period of excessively low interest rates, engineered by the Federal Reserve, has fostered the emergence of numerous asset bubbles and not just in real estate. It is only a matter of time before some of them begin bursting.

Unwise economic policies at home and abroad could easily trigger an economic downturn. A trade war, or real war, launched by an impulsive president, a poorly executed Brexit, or an overleveraged Chinese economy suddenly experiencing slower growth are just some of the possible triggers.

That inevitable downturn will be a real-world test of the Fed’s stress-test assumptions, a test the Fed may flunk because of shortcomings in a stress-testing process that even the best design will never overcome. 

First, the test does not acknowledge that economic downturns are not spread evenly across the United States or the globe. While the largest banks have substantial geographic diversity, some are more exposed to certain regions of the United States than other regions. Consequently, bank loan-losses and subsequent bank weaknesses and failures could be geographically concentrated. 

For example, since 2009, over half of the losses the FDIC experienced occurred in banks headquartered in just four states — California, Florida, Georgia and Illinois. At the other end of the spectrum, eight states, plus the District of Columbia, have experienced zero bank failures.

The next wave of banking problems — and failures — almost certainly will exhibit a similar maldistribution of losses and failures. That likely will be true, too, for U.S. banks with foreign loss exposures.

Second, problems afflicting banks often erupt elsewhere in the financial system, often in the murky world of shadow banking, where regulators usually are the last to know — much less understand — what is happening. That definitely was the case in the years leading up to the 2008 financial crisis.

That almost certainly will be true prior to the next crisis, which, despite Federal Reserve Chair Janet Yellen’s recently stated belief to the contrary, may yet occur in her lifetime.

Third, and perhaps most critically, how well, how timely and how on-target will bank managements, regulators and investors (i.e., stock-market discipline) respond to the next serious economic downturn? No stress test can adequately factor in those critical human variables, which is why not much confidence should be placed in the just-announced stress-test results.

Put another way, if bankers, investors and regulators continue to be slow to recognize and then deal with emerging problems in the financial system, then chaos and crisis can easily ensue.

Compared to Europe, the U.S. system responded relatively well to the last crisis, albeit still at great cost to the economy. It is amazing how several European countries, notably Italy and Spain, continue to suffer economically because their banks have not been forced to recognize all the loan losses still buried in their balance sheets and pay the consequences. China suffers from the same affliction. 

While the U.S. banking system today is well-capitalized by traditional measures, the question remains: How well will this system — and its key players — respond to the next economic downturn? How well will economic incentives and safeguards operate the next time? The just-concluded stress tests provide no answers, or even insights, about that future.

Bert Ely is the principal of Ely & Company, Inc., where he monitors conditions in the banking and thrift industries, monetary policy, the payments system and the growing federalization of credit risk.

The views expressed by contributors are their own and not the views of The Hill.